Thursday, August 12, 2010

There has been a lot of talk recently about the capacity of states to accumulate debt during recessions. This usually is merely background for an argument over whether states should use more deficit fiscal spending to try to stimulate their economies out of recession, or a sluggish "jobless" recovery. One side of that debate typically argues that if debt grows too large, bond investors will demand a high interest rate premium for continuing to extend credit. If this premium gets too large, the debt burden can become crippling, triggering either a currency crisis or a debt default, each of which has adverse long-run consequences for growth. Even if interest rates on bonds are at acceptable levels right now, things can turn irreversibly on a dime. Therefore, debt should be kept at moderate levels even if that requires short-run "austerity", so that the long-run solvency of states is maintained. Proponents of this view include most European governments, almost the entire Republican party and right-wing punditocracy, and significant chunks of the center-left technocracy (e.g. Robert Rubin).

The other side of the debate often begins by repeating Keynes' famous "In the long-run we're all dead" before saying that if pressures on interest rates rise, then perhaps austerity is an appropriate course of action. In the present case interest rates on debt in many advanced economies, particularly the U.S., are at very low levels. They insist, therefore, that more short-run deficit spending is not only possible, it is advisable and necessary to return economies to their trend growth rates. Refusing to do so in order to prevent a debt spiral is capitulation to "Invisible Bond Vigilantes". In these circumstances, austerity programs are mere shadow-boxing, but with real negative consequences for those affected by the economic downturn. Proponents of this view include Paul Krugman, Brad DeLong, Martin Wolf, elements of left political parties, and others. As someone (perhaps DeLong, tho I can't find it) put it, "Lord, give me fiscal balance, but not yet."

How to evaluate these claims? One way is to consider the internal logic of the arguments. Let's start with a fact: interest rates on sovereign debt in the United States are at very low historic levels, despite the fact that deficits are at near-record levels and debt-to-GDP is increasingly quickly. It is unlikely that investors believe that sovereign default has become less likely over the past few years, so we should conclude that U.S. debt has become safer relative to other assets. This is compatible with the argument made by Felix Salmon that equity markets are likely to remain very volatile in the future, and with the argument made by Brad DeLong that the demand for high-quality assets is currently outstripping supply (because risk appetites are low, and the probability of default on corporate debt and non-U.S. sovereign debt is much higher than that of U.S. debt).

When we think of the interest rate on U.S. debt as a product of its relative relationship to other assets, we can conclude that interest rates will rise when the gap narrows. This can happen in two ways: 1. The value of other assets improves (either because the risk appetite increases, or economic conditions stabilize so other assets become less risky); 2. The value of U.S. debt declines (because the capability to repay weakens). This relationship implies a few things. First, it can be unwise to increase deficits even if the Bond Vigilantes remain Invisible, because almost all debt incurred now will have to be rolled over in the future. Assuming that the value of other assets eventually improves as the global economy stabilizes, demand for U.S. debt relative to other assets will be lower than it is today, so rolling over will require paying a significantly higher interest rate than today's. Paying those rates will dampen economic growth in the future. In this scenario, fiscal stimulus today almost certainly has a negative medium-run multiplier, even if the short-run multiplier is positive. As far as I know, no one has made any detailed argument that the latter is greater than the former. If it isn't, then the U.S. shouldn't take on more debt.

Another way to think about this is to consider the relationship between states and investors in a world where capital is more-or-less mobile across national borders. Not that pundits or economists are aware of it, but there's been some IPE research on this question. One book by Stanford's Michael Tomz, Reputation and International Cooperation, argues that governments have "types" reinforced by patterns of behavior. Some states always pay their debts ("stalwarts"), others pay when times are good but not when they are bad ("fair-weathers"), and others often default ("lemons"). Tomz argues that the interest rates states pay are a function of their reputation, which itself is a function of past behavior. So, a stalwart state that has kept its debt at sustainable levels and always paid it back on time will pay low interest rates. This is clearly the position that the U.S. is presently in, so why not trade a bit on that reputation now, when we need it most? Tomz' research suggests that we can, but not forever. If investors begin to think that the U.S. will be incapable or unwilling to repay on time, interest rates will increase sharply. These are not Invisible Bond Vigilantes; they are Visible, but the U.S.' reputation (unlike, say, Greece's) has so far withstood the scrutiny. Still, the breaking point does exist, even if it's hard to locate, and once the U.S.' reputation takes a hit it will take a very long time to get it back. This makes all future borrowing more expensive, so revert to previous point about multipliers.

Another line of research, by UNC-Chapel Hill's Layna Mosley (my thesis advisor), focuses on what government policies are important to investors. In her book Global Capital and National Governments (article version here), she found that governments have "room to move" when setting policy. That is, that investors focus somewhat narrowly on a few policy choices, and don't care very much about anything else. According to her work, investors care most about three things: inflation rate, current account balance, and government deficits. Of these, inflation rate is by far the most important and deficits the least: on average a 1% decrease in the budget balance is associated with a 0.05% increase in the interest rate. (Although it should be noted that the 2010 U.S. deficit will be larger than any in her sample.) This suggests that the Fed may be correct in pursuing a less-expansionary monetary policy than many have called for (i.e. Sumner, Krugman, others) but that there is still room for the government to pursue fiscal expansion.

So what does all this sum up to? It's not perfectly clear, but my read is that the U.S. likely has the ability to pursue more deficit fiscal expansion, especially if medium-run growth prospects remain weak, but that there are limits. Where those limits are isn't obvious, so trying to find them by playing chicken with Bond Vigilantes is like approaching a cliff while blindfolded: it's unadvisable. The marginal benefit of successfully toeing the line (James Dean in the video above) is fairly small, while the cost of tumbling over is enormous (poor Buzz). And even if the U.S. is not at risk of default, an increase in other asset values could still make the cost of servicing the national debt increase markedly.

That doesn't mean I support austerity for the U.S. While interest rates remain low we are not in a precarious position, so retrenchment would be foolish. But so would speeding toward the cliff with our hands tied.

4
comments:

The arguments of those who call for fiscal consolidation do not rely exclusively on fears of future spikes in interest rates. Even at historically low interest rates, the cost of debt service will be exceptionally high and, more importantly, unsustainable for the US.

For instance, a guy called Erskine Bowles, I think he has something to do with the UNC ;-), is wary of interest payments of the US government amounting to $2 trillion annually by 2020.

The best way for anyone to learn this stuff is to work through estimates. Study how IMF, OMB, David Walker or Laurence Kotlikoff come up with their fiscal projections. If you disagree with them and think "more deficit fiscal expansion" is possible, explain why using figures. Perhaps you can tell us why their discount rates are wrong, why projections of non-discretionary spending are overstated and so forth.

Do the math. Otherwise, you end up like just another Drezner (ideologically biased) or Pettis (numerically challenged) with no numbers to show for it.

More likely than not, you too will come to the conclusion that the US is bankrupt.

So, I glanced at the Mosley piece you link to and I have a question/comment.

She uses lags for most of her independent variables (t-1 & t-2) and she writes that "to determine the cumulative effects of each (lagged and current) independent variable, I combine the coefficients."

I wondered what this meant and looked at the "disaggregated coefficients" in appendix. Basically, the author takes all coefficients of the lags and of the main terms, and simply adds them together.

I'm not too familiar with work with multiple time lags, but I know that this approach would be wrong in the simple case of a single t-1 lag. To get the dynamic effect, you need to multiply both coefficients at t, and trail it in an exponentially decreasing function for all t+n until the effect vanishes. You can't just add them together and interpret that sum as your effect.

Similarly, you can't just add standard errors and treat this as your estimate of uncertainty. An analytical solution is actually hard to get, but it's easy to work with simulations in order to provide a confidence band based on the standard deviation of simulated values (e.g. using CLARIFY).

I want to believe the author, but I'd really need someone to explain to me why this could be right.

This makes me think of another Mosley (2007) paper on which I did some basic replication work. If I remember right, she misinterprets an interaction term, and it turns out that one of the main findings of the paper is essentially a null result.

Emmanuel, I have looked the IMF projections, as well as the OECD projections. I don't agree that they say what you think they say, and in any case they revise them pretty significantly every few months.

Anon, if you have questions about Mosley's methodological choices I'd suggest you e-mail her, since she'd be able to give you more info than I. My guess is that since she modeled an additive relationship between the variables, she thought that adding the coefficients for a "total effect" was appropriate. She did report them separately, as you noticed, and they retain significance in almost all cases. She also modeled it as an AR(1) process, which includes an exponential decay function.

Anyway, I don't want to comment too strongly because I'm not exactly sure why she made those choices. I'm sure she'd be happy to answer any questions via e-mail.